~ Investment Strategy

Perplexed by the equity rally

The good ISM has clearly put some spring into the market’s step. I remain surprised at how strong this rally has been — I was expecting a rally on Greece, but not one like this.

We have now had five strong up days (including today) in the S&P 500. I have defined a strong up day as a day where yesterday’s close is in or below the bottom third of today’s bar and today’s close is in the top third of today’s bar, and where the true range is greater than half the 10-day average true range (just so that piddling little days with the right shape don’t count). In the past 30 years, there have only been three occasions when the market has had five strong days in a row (see below). There are no instances where it has had six such days in a row.

30/07/1987: Market had a small pullback and then headed towards its 1987 peak.

09/10/2009: Market continued upward.

09/01/2011: Who knows.

I have also had a look at sector performance. The bounce of the last few days has been driven by industrials and materials, and to a lesser extent consumer discretionary, energy and tech. If this rally was all about Greece, surely financials should be bouncing as the risk of a sovereign default causing trouble in the banking system recedes.

Let’s look at other markets. Copper has rallied a little; oil did so initially and then took a pause, and the same goes for platinum and palladium. Treasuries have tanked, and so has gold. The USD looks much the same — it dropped a little at the start of the equity bounce and is actually up today. In other words, commodities have had the limp bounce that I predicted once the Greek vote was passed, and the USD was as usual their mirror image with a weak decline. Even the EUR has not managed to rally above its most recent, lower, high. Yet Treasuries have undone almost half their recent upward run, and equities have had a once-a-decade move. Why?

There are, of course, other factors at work here. For example, the IEA reserve drawdown and the oil price fall might be reasons to be optimistic about growth.

Perhaps the most coherent explanation is this. As I have said before, the best model of the equity market is a nervous American child. This child read some headlines about poorer economic data, but didn’t really understand for a while; but then the message started to get through, and the child’s mood became a little down. Then Greece was in the news, and the child felt really frightened; but now Greece is “dealt with”, the bad headlines have blown away like clouds after a thunderstorm, and the suddenness of the change has made the child euphoric.

UPDATE: I have had a look at the trading potential here. There are 10 occasions when the market has had four strong days. A simple strategy that buys the open of the fifth day and holds for two weeks has a success rate of 80% and a profit factor of 3.98 (which is good). If we look at three strong days, there are 57 occasions, the success rate is 63% and the profit factor is 1.27. The odds seem to favour a continuation of this rally.

UPDATE2: The market has rallied 5.6% in five days. Such rallies happen fairly often — the S&P 500 has rallied 5.6% or more in five days 51 times in the past 30 years. It is the one-sidedness of this rally that makes it unusual.